Martin Wolf Weighs in On Rising Bond Rates

Martin Wolf has this to say about the rise in long-term interest rates that has the Fed puzzled and others worried:

The jump in bond rates is a desirable normalisation after a panic. Investors rushed into the dollar and government bonds. Now they are rushing out again. Welcome to the giddy world of financial markets.

At the end of December 2008, US 10-year Treasury yields fell to the frighteningly low level of 2.1 per cent from close to 4 per cent in October. Partly as a result of this fall and partly because of a surprising rise in the yield on inflation-protected bonds (Tips), implied expected inflation reached a low of close to zero. The deflation scare had become all too real.

What has happened is a sudden return to normality: after some turmoil, the yield on conventional US government bonds closed at 3.5 per cent last week, while the yield on Tips fell to 1.9 per cent. So expected inflation went to a level in keeping with Federal Reserve objectives, at close to 1.6 per cent. Much the same has happened in the UK, with a rise in expected inflation from a low of 1.3 per cent in March to 2.3 per cent. Fear of deflationary meltdown has gone. Hurrah!

Wolf also responds to the debate among Niall Ferguson, Paul Krugman, and John Taylor.

Is This Economic Crisis a Key Turning Point in History?

Like other observers, Niall Ferguson says maybe:

Could this be one of those great turning points in history, when the balance of power tilts decisively away from an established power and towards a rising challenger? It is possible. Financial crises often accelerate the gradual shifting of the geopolitical tectonic plates; they are to history what earthquakes are to geology.

It was inflation that undermined the foundations of Habsburg power and opened the way for the Dutch Republic. It was the disastrous Mississippi Bubble of 1718-19 that fatally weakened ancien régime France, while Britain survived the contemporaneous South Sea Bubble with its fiscal system intact. For most of the nineteenth century, financial crises in the United States had only marginal effects on the City of London. By 1907, however, a Wall Street crash could send a shockwave across the entire British Empire, a harbinger of a new era of American power.

Something similar may be happening as a consequence of the American financial crisis that began nearly two years ago. The flapping of a butterfly's wings may trigger a hurricane in the Home Counties; in much the same way, a crisis in the market for subprime mortgages could signal the waning of US hegemony and the advent of a Chinese century.

The New Normal for Money Multtipliers?

Here is an update on the M1 money multiplier and the MZM money multiplier. Not much change in the series. Is this the new normal for money multipliers? (Click on figures to enlarge.)

Corporate Bond Spreads Update

Here is an update on the BAA corporate bond yield minus AAA corporate bond yield spread. The overall spread is still elevated at 252 basis points in May 2009, but this is down from the December 2008 peak of 338. (Click on figure to enlarge.)

GDI vs. GDP

Late last year James Hamilton referenced the work of Federal Reserve economist Jeremy Nalewai that shows Gross Domestic Income (GDI) does a better job than Gross Domestic Product in finding turning points leading to a recession. Given all the talk about green shoots, I thought I would take a look at real GDI to see how it is performing relative to real GDP:

(Source: BEA table 1.10, 1.1.4, 1.1.1)

This figure shows real GDI experienced a pronounced downturn of -8.2% in 2008:Q4 versus the -6.3 for real GDP. It also shows a sharp bounce back to -3.7% in 2009:Q1 compared to the -5.7% for real GDP. If GDI does as good a job at finding turning points for recoveries as it does recessions then this improvement is a promising development.

Update: I had my quarters labeled incorrectly in the above paragraph and fixed them.

Assorted Musings

Here are some assorted musings:

1. First there was the interest-rate conundrum in the mid-2000s that stumped the Fed, now there is the steepening yield curve mystery from last week that has the Fed perplexed. The Treasury yield curve is so frustrating some times for the Fed. Fortunately, Rebecca Wilder has some insights on this latest yield curve development.
2. Is Paul Krugman throwing the baby out with the bathwater in his latest column? He argues the fundamental reason we are in this bind is that the financial sector was deregulated in the 1980s, financial innovation took off, and as a result there has been too much borrowing since then. I think many observers would agree there has been a lot of borrowing, but does Krugman really want to inhibit financial innovation just because it makes its easier for individuals to make bad financial decisions? Most inventions and innovations have the potential for creating problems, but instead of outlawing them we try to manage them.
3. Brad Sester notes total U.S. borrowing from the rest of the world is down, even though U.S. government borrowing is exploding. That is because households and business are borrowing a lot less. As a result, government borrowing is offsetting the fall in private borrowing. Here is his summary graph (click on figure to enlarge):
   
   
As Sester explains, though, once the economy recovers and the private sectors starts borrowing again, government borrowing must come down to keep total U.S. borrowing in line. Observers like John Taylor, Niall Ferguson, John Maudlin, and others, however, are concerned that future government spending will not be reversed once the economy recovers. If so, the real question becomes what is the U.S. Debt-to-GDP number that is too big?

Putting Some Teeth into the SDRs

The WSJ's RTE blog is reporting that the IMF will soon be issuing bonds denominated in the IMF's currency called the SDRs. Interestingly, those countries eager to see alternative reserve currency emerge are some of the first to express interest in these bonds:

The International Monetary Fund is putting final touches on its plans to issue its first bonds. Russia has already said it would buy $10 billion of the bonds, which would be priced in the IMF’s quasi-currency, “special drawing rights.” SDRs are a basket of currencies consisting of the euro, yen, pound sterling and U.S. dollar. As of Friday, 1 SDR equals $1.55.

China, Brazil and India also have said they are interested in buying IMF bonds, with China likely to purchase more than $20 billion of instrument. The IMF wants to issue bonds as a way to build up its lending war chest as the global economic nosedive continues.

Might this development be the starting point for making the SDRs an alternative reserve currency?